Monday 20 January 2020

Brendan Keenan: Common sense not a good guide to the Great Recession

NO, it wasn't Lehman Bros. The foibles of Dick Fuld and his merry band have been cited by the politicians involved as the cause of much of our troubles, from the collapse of Anglo to the bailout itself.

That was never plausible, but it seems reasonable to think that the global financial conflagration, for which Lehman's lit the spark, has much to do with the appalling severity of the Great Recession.

Well, maybe even that is wrong. The term "Great Recession" is now next to official, given its use by the International Monetary Fund, no less, to describe the global crisis.

Ireland might qualify for "Greater Recession", given the record-breaking character of its downfall. But, according to the said IMF, things might have been just as bad in Ireland even if there had been no Lehman's and no global pandemonium.

That is one interpretation of the recent IMF analysis of the effects of a high level of household debt on recessions. The point of the analysis (which therefore attracted most attention) was the merits of forgiving household debt -- usually mortgages -- in such circumstances.

Dissection

That meant less coverage for the report's dissection of recessions which are preceded by a rapid increase in household debt.

There was mention of the finding that they typically last at least five years, and that the loss of economic output tends to be four times as severe as in recessions not accompanied by such debt, but there was a good deal more about the nature of these debt busts which deserves attention.

Some of it appears to confirm what common sense would say anyway -- such as indebted households saving more and spending less. Indeed, in what might be called "plain vanilla" recessions, unaccompanied by large credit booms, households borrow more during the downturn, thereby aiding recovery.

Other bits of evidence run counter to what common sense expects -- including the absence of a "Lehman effect". When households over-borrow, the subsequent crashes seem to be just as bad even when they do not include a financial crisis.

Of course, the financial crisis produces its own contractionary effects, which is why this is a global Great Recession. But, as the ESRI pointed out towards the end of the boom, the Irish economy was heading for the rocks anyway.

They even calculated that it could not last beyond 2015, because excessive internal inflation would bring the trading economy to a halt. Heaven only knows what household debt would have reached by then, so our final state might have been even worse than it is.

On the IMF's figures, debt recessions seem even more severe than the worst-case scenarios postulated back then. Ordinary recessions, about which we fulminated so much in the past, look mere bagatelles compared with these household busts.

The difference is not even all due to collapsing house prices -- as again one might expect. The IMF study covers only recessions involving house price crashes. It identified no fewer than 99 examples among 24 IMF member states, plus Taiwan. (There is nothing new under the sun.)

The analysts then compared those house price busts which had a prior large increase in household debt with those which had not.

The differences are stark. Household spending falls by more than four times the amount when the property crash is accompanied by a large debt burden.

"It seems to be the combination of house price declines and pre-bust leverage that explains the severity of the contraction," the authors say.

The combinations vary widely. In particular, the behaviour of Irish house prices was unusual -- also in an unexpected way. Despite what is commonly said, the rise in Irish house prices was not that extraordinary, but the subsequent fall certainly is.

Measured from 2002, the real increase in Irish prices was less than that of Denmark, Spain and Iceland. (Iceland was in a class of its own, with real prices more than doubling.) The UK and US were not far behind Ireland.

But none of the eight countries covered have had a fall in house prices to compare with Ireland's. By 2010, real prices here were back to the 2002 level. That is also true of the US, but the fall started earlier and was less precipitate, while Irish prices have fallen by more since.

They are now around 2000 levels. Apart from the US, house prices in the other countries were still 20-50pc above 2002 in real terms, with Iceland's 190pc higher. Prices hardly dipped at all in Britain.

Of course, only in the graph is everyone in the same position in 2002: in reality there would have been different levels of over or under valuation then but Ireland's record is still unique.

Ireland does stand out in terms of the rise in the household debt burden and it is the combination which proved lethal. Debt rose by 90pc from 2002-08, although the Danes and Dutch ran us close. (There is some talk among economists about delayed, but looming, problems in those economies. Watch this space.)

In Ireland's case, we know that households have reduced debt quicker than anyone else, but falling incomes and rising taxes mean only a few points have been knocked off the debt/income ratio.

Perhaps this helps explain the startling graph in the study, which shows the percentage of mortgages in arrears. The 6pc figure for Ireland (which has doubled since), and 9pc for the US (which has fallen since) compare with 2.5pc in arrears in Britain and Spain.

Problems may have been deferred in those countries too, but the financial stress indicated by the huge Irish arrears must be part of the explanation for the extraordinary collapse in house prices.

It is also partly explained by the fact that those high levels of household debt are so concentrated in mortgages -- mortgages taken out mostly by young people during the bubble years.

This creates the curious situation where net household wealth -- €600bn of assets minus €200bn of debt -- is still greater than it was when the boom/bust cycle began in 2003, but is most unevenly spread.

Most people approve, in theory at least, of equalising income differences between richer and poorer. Equalising wealth to any degree, by taxing assets and relieving debt, is an entirely different matter.

Finding solutions is a taxing question in both senses of the word but, before we start, we must at least be sure that we understand the nature of the problem.

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